Brian Jordan is interviewing for a junior equity analyst position at Orion Investment Ad- visors. As part of the interview process, Mary Benn, Orion's Director of Research, provides Jordan with information about two hypothetical companies, Alpha and Beta, and asks him to comment on the information on their financial statements and ratios. Both companies pre- pare their financial statements in accordance with International Financial Reporting Standards (IFRS) and are identical in all respects except for their accounting choices. Jordan is told that at the beginning of the current fiscal year, both companies purchased a major new computer system and began building new manufacturing plants for their own use. Alpha capitalized and Beta expensed the cost of the computer system; Alpha capitalized and Beta expensed the interest costs associated with the construction of the manufacturing plants. In mid-year, both companies leased new office headquarters. Alpha classified the lease as an operating lease, and Beta classified it as a finance lease. Benn asks Jordan, “What was the impact of these decisions on each company's current fiscal year financial statements and ratios?" Jordan responds, "Alpha's decision to capitalize the cost of its new computer system in- stead of expensing it results in lower net income, lower total assets, and higher cash flow from operating activities in the current fiscal year. Alpha's decision to capitalize its interest costs instead of expensing them results in a lower fixed asset turnover ratio and a higher interest coverage ratio. Alpha's decision to classify its lease as an operating lease instead of a finance lease results in higher net income, higher cash flow from operating activities, and stronger solvency and activity ratios compared to Beta." Jordan is told that Alpha uses the straight-line depreciation method and Beta uses an accelerated depreciation method; both companies estimate the same useful lives for long-lived assets. Many companies in their industry use the units-of-production method. Benn asks Jordan, “What are the financial statement implications of each depreciation method, and how do you determine a company's need to reinvest in its productive capacity?" Jordan replies, “All other things being equal, the straight-line depreciation method results in the least variability of net profit margin over time, while an accelerated depreciation method results in a declining trend in net profit margin over time. The units-of-production can result in a net profit margin trend that is quite variable. I use a three-step approach to estimate a company's need to reinvest in its productive capacity. First, I estimate the average age of the assets by dividing net property, plant, and equipment by annual depreciation expense. Second, I estimate the average remaining useful life of the assets by dividing accumulated depreciation by depreciation expense. Third, I add the estimates of the average remaining useful life and the average age of the assets in order to determine the total useful life." Jordan is told that at the end of the current fiscal year, Alpha revalued a manufacturing plant; this increased its reported carrying amount by 15 percent. There was no previous down- ward revaluation of the plant. Beta recorded an impairment loss on a manufacturing plant; this reduced its carrying by 10 percent. Benn asks Jordan “What was the impact of these decisions on each company's current fiscal year financial ratios?" Jordan responds, "Beta's impairment loss increases its debt to total assets and fixed asset turnover ratios, and lowers its cash flow from operating activities. Alpha's revaluation increases its debt to capital and return on assets ratios, and reduces its return on equity." At the end of the interview, Benn thanks Jordan for his time and states that a hiring deci- sion will be made shortly.
Depreciation Methods
The word "depreciation" is defined as an accounting method wherein the cost of tangible assets is spread over its useful life and it usually denotes how much of the assets value has been used up. The depreciation is usually considered as an operating expense. The main reason behind depreciation includes wear and tear of the assets, obsolescence etc.
Depreciation Accounting
In terms of accounting, with the passage of time the value of a fixed asset (like machinery, plants, furniture etc.) goes down over a specific period of time is known as depreciation. Now, the question comes in your mind, why the value of the fixed asset reduces over time.
Jordan’s response about the impact of the diff erent
margin is most likely incorrect with respect to:
A. accelerated depreciation.
B. straight-line depreciation.
C. units-of-production depreciation.
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